Bernanke Should Buy Buicks Instead of Bonds: Caroline Baum

Commentary by Caroline Baum

Dec. 4 (Bloomberg) -- It tells you just how far we’ve come when the headline, “Fed May Buy Treasuries,” gets a reaction.

Buying Treasuries is the age-old way of adding reserves to the banking system, setting in motion the money-creation process.

Historically, these so-called permanent open market operations were designed to have no impact on the shape of the yield curve. The goal was simply to satisfy the banking system’s demand for reserves.

Treasury securities used to make up the lion’s share of the Federal Reserve’s balance sheet. No longer. As of Nov. 28, the Fed held $476 billion of securities carrying the full faith and credit of the U.S. government, less than a quarter of its balance sheet. One year ago, the comparable figures for the Fed’s Treasury holdings were $780 billion and 90 percent.

When the banking system starts functioning again, and the Fed has to mop up all the excess reserves banks are holding instead of lending, the reality is “it doesn’t have enough Treasuries,” said Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago.

Banks were holding $605 billion of reserves in excess of the amount required as of Nov. 19. “Maybe the Fed will have to raise reserve requirements,” Kasriel says. “It’ll be 1937 all over again.”

Many Great Depression scholars, including the late Milton Friedman and Anna Schwartz, point to the Fed’s doubling of reserve requirements in 1936-1937 as triggering the second leg down in the economy, which was recovering in the mid-1930s.

Twisting for Naught

With the Fed’s target benchmark rate at 1 percent and the effective rate less than half that, Fed Chairman Ben Bernankesaid earlier this week that the bank may buy “longer-term Treasury or agency securities on the open market in substantial quantities,” bringing down long-term interest rates in an effort “to spur aggregate demand.”

This wouldn’t be the first time policy makers attempted to influence the shape of the yield curve. The twist was the rage in 1961 as well -- both the dance and the combined Treasury-Fed operation to have their way with the yield curve.

“Operation Twist” was an effort to prop up short-term interest rates to attract capital flows from abroad and lower long-term rates to stimulate investment. The U.S. suffered through a mild recession in 1960-1961. We were all Keynesians then as we seem to be now, tossing out increasingly large sums -- “I have $700 billion, do I hear $800?” -- for a fiscal-stimulus plan.

The Treasury concentrated its borrowing at the short end of the yield curve and purchased long-term bonds for its trust accounts. The Fed did away with its “bills only” policy for conducting open-market operations and bought long-term bonds instead.

Zero Room Left

The experiment in yield-curve-sculpting was considered a failure, although a joint Treasury-Fed study on the government securities market found half-hearted participation by both parties.

What’s more, the Fed’s purchases of long-term bonds were “sterilized” by offsetting operations, said Allan Meltzer, professor of political economy at Carnegie Mellon University in Pittsburgh and a Fed historian. As with sterilized foreign exchange intervention, the effect is short-lived.

That was then, this is now. With the funds rate close to zero and the Fed committed to “quantitative easing” -- ditching its target rate and going for volume instead -- it has to inject reserves into the banking system by buying something.

Fords for Fed?

“The basic premise of monetary economics is that if you create enough money, at some point there will be more than people want to hold and they’ll spend it,” Meltzer says.

That hasn’t happened so far. The Fed will keep pumping until it gets traction.

Even unsterilized bond purchases may fail to lower long-term rates to any significant degree for any significant time. Long rates are the sum of current and expected future short-term rates. Today’s 10-year note yield of 2.7 percent isn’t sustainable if investors anticipate, say, a 3 percent overnight rate two years from today. In that case, they’ll demand some compensation -- a liquidity premium -- for holding long-term assets.

Lowering risk-free long-term rates is really beside the point: Those rates are already at historic lows. To stimulate housing demand, the Fed committed itself to buy as much as $600 billion of debt issued by government-sponsored enterprises, including Fannie Mae and Freddie Mac, and the mortgage securities they guarantee.

Saleable Items

The goal is to get reserves into the banking system, which the Fed can do by purchasing anything. A second objective is “acquiring some assets they can sell” when it comes time to unwind the monetary stimulus, Meltzer says.

What about buying autos? The Fed could kill two birds with one stone.

“They need to have stuff they can sell,” Meltzer says. “The Fed has used its portfolio of Treasuries instead of money, taking on bad assets and giving (primary dealers) Treasuries in exchange.”

That’s too bad for Detroit automakers, which could use a quality- and price-insensitive buyer right now.

(Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.)

To contact the writer of this column: Caroline Baum in New York at cabaum@bloomberg.net.